Financial Misreporting Research Articles

What Are You Saying? Using topic to Detect Financial Misreporting

ABSTRACTWe use a machine learning technique to assess whether the thematic content of financial statement disclosures (labeled topic) is incrementally informative in predicting intentional misreporting. Using a Bayesian topic modeling algorithm, we determine and empirically quantify the topic content of a large collection of 10‐K narratives spanning 1994 to 2012. We find that the algorithm produces a valid set of semantically meaningful topics that predict financial misreporting, based on samples of Securities and Exchange Commission (SEC) enforcement actions (Accounting and Auditing Enforcement Releases [AAERs]) and irregularities identified from financial restatements and 10‐K filing amendments. Our out‐of‐sample tests indicate that topic significantly improves the detection of financial misreporting by as much as 59% when added to models based on commonly used financial and textual style variables. Furthermore, models that incorporate topic significantly outperform traditional models when detecting serious revenue recognition and core expense errors. Taken together, our results suggest that the topics discussed in annual report filings and the attention devoted to each topic are useful signals in detecting financial misreporting.

Executive Network Centrality and Corporate Reporting

This paper investigates the association of corporate reporting and executive network centrality, which measures an executive’s relative position in a massive network consisting of outside corporate leaders. I find that high-centrality chief executive officers (CEOs) and chief financial officers (CFOs) are generally more likely to engage in financial misreporting than low-centrality CEOs and CFOs. I also find that the influence of CFO network centrality is greater than that of CEOs in financial misreporting. Further analyses show that the monitoring effect of internal governance mechanisms on high-centrality executives is very limited and that the discipline of the managerial labor market is weaker for high-centrality CFOs as well. My results hold for a subsample subject to exogenous shocks to CFO connectedness and are robust to a series of alternative specifications including using CFO fixed effects. Taken together, my findings suggest that corporate reporting can be influenced by executives’ social network position, with high-centrality CFOs using their social power and influence to make adverse corporate reporting decisions to gain personal benefits.

Protecting Wall Street or Main Street: SEC Monitoring and Enforcement of Retail-Owned Firms

This study examines whether the percentage of retail ownership of a firm is associated with the likelihood that the firm is subject to monitoring and enforcement by the two largest divisions of the SEC. We find a negative association between retail ownership percentage and SEC monitoring. In contrast, we find a positive association between retail ownership percentage and SEC enforcement. We acknowledge that the objective function of the SEC in terms of monitoring and enforcement of corporate registrants is complex and nuanced, and we do not contend that these associations are at all causal. However, the results suggest that the SEC is less likely to monitor firms with high retail ownership, potentially leaving retail investors more vulnerable to unresolved financial reporting issues. At the same time, the SEC is more likely to enforce upon firms with high retail ownership, potentially harming retail investors when the firm is accused of egregious cases of perceived financial misreporting.

Financial misreporting and peer firms' operational efficiency

AbstractWe investigate the impact of financial misreporting on peer firms’ operational efficiency, defined as a firm’s efficiency in converting investments into revenues. We find that, on average, peers’ operational efficiency declines after rival firms misstate their financial performance. However, we also find that the impact of financial misreporting is not homogeneous across peer firms. The negative effect is mainly driven by non‐misstating firms that had high performance. For firms that had lower past performance, the negative effect is significantly weaker, suggesting that the perceived competition induced by misreporting has a more positive effect. In addition, we document that the effect of misreporting is influenced by peer firms’ external financing need, industry leadership status and information environment.

CEO tenure and audit pricing

We examine the relationship between CEO tenure and audit fees. After controlling for client and auditor attributes in the analyses, we find that audit fees are higher in the initial 3 years of CEOs’ service, suggesting that CEOs in their early career are more likely to show high risk-taking behavior and manage earnings that increases the probability of financial misreporting. Auditors incorporate this risk in their audit pricing decisions resulting in higher audit fees. We also find that audit fees are higher in the final year of CEOs’ service, supporting the argument for departing CEOs’ horizon problem that CEOs in their final year are more likely to manage earnings, and auditors perceive this action as increasing reporting risk in their audit pricing decisions, resulting in higher audit fees. However, the firms with more effective audit committees pay relatively lower audit fees in initial years of CEOs’ service indicating that effective audit committees reduce auditors’ assessed risk during this time-period resulting in lower audit fees. We do not find any evidence on the effect of firms’ CFO power and corporate social responsibility performance on audit fees in these two time-periods of CEOs’ service. The main results hold in a battery of supplemental tests that include the effect of several CEO characteristics, client bargaining power and the effect of SOX. Our study extends CEO characteristics and audit fee literature, and have implications for auditors in their client acceptance and audit pricing decisions, and for regulators to identify the filers with higher financial reporting and audit engagement risk.

The Effect of Local Tournament Incentives on Firms' Performance, Risk-Taking Decisions, and Financial Reporting Decisions

ABSTRACT This study documents the existence of local employment preferences for corporate executives and examines how the compensation of executives' local peers affects their own performance, risk-taking decisions, and financial reporting decisions. We find that external hires of new CEOs (CFOs) are five (eight) times more likely to be from local firms than non-local firms. We also find that local tournament incentives—as proxied by the pay gap between an executive and higher-paid executives in the area—are associated with stronger performance, greater risk taking, and more financial misreporting. We find consistent results using a difference-in-differences analysis that exploits plausibly exogenous variation in local tournament incentives caused by the sudden death of a local CEO. Our findings are consistent with executives taking actions to compete for a promotion to a nearby firm with higher pay.

Financial versus operating liability leverage and audit fees

We argue that different types of leverage have different implications for audit risk and audit fees, and hence need to be separately examined. Using data from the years 2004 to 2016, we find that operating liability leverage is positively associated with audit fees and that financing leverage is negatively related to audit fees. The results suggest that the benefits from monitoring effects of financial leverage outweigh the costs associated with the risk of financial distress and financial misreporting. We also find that estimated operating liability leverage has a bigger effect on audit fees than contractual operating liability leverage, consistent with suggestions that auditors are more conservative in the presence of higher estimation risk. Thus, our findings highlight the importance of recognizing sources of leverage in audit risk in general and audit fee models in particular.

Revealing Corporate Financial Misreporting

ABSTRACTThis study examines how frequently firms restate when they materially misstate their financial statements using stock option backdating as the setting. Stock option backdating provides a unique opportunity to study this issue because it is possible to estimate misstatements with publicly available information to a high level of confidence, and the extensive media coverage of backdating notified boards of directors of the significant risk of misstatement. After identifying firms that materially misstated earnings due to stock option backdating with 95 percent (99 percent) probability, we find that only 11.5 percent (16.1 percent) of these firms subsequently restated. Restating firms are larger, have greater board independence, higher litigation risk and ROA, a lower market‐to‐book ratio, less discretionary accruals, and are more likely to have a CFO that was not involved in backdating. Restating firms are also more likely to disclose other adverse news, face securities litigation, and turn over the CFO than firms that appear to materially backdate but do not restate. Since nearly 9 of 10 firms failed to restate, our results give pause to researchers who use restatements as an indicator of misreporting, and to regulators who levy penalties on those who do self‐report.

Double Trouble: An Analysis of IRS Attention and Financial Reporting

We examine whether the IRS uses public information to obtain qualitative signals regarding the quality of firms’ financial information or management integrity. Using the procurement of public information as a proxy for IRS attention, we test whether public signals of poor information quality (restatements) lead to an increase in IRS attention. To begin, we document that the IRS is both more likely and quicker to acquire public filings announcing a restatement than any other filing of the firm. Furthermore, we examine instances in which the IRS is more likely to learn of a restatement and find an increase in attention around both press releases and media coverage of the restatement. Next, we examine the implications of increased IRS attention. Employing path analysis, we find that IRS attention is associated with both higher levels of future tax settlements, and a greater likelihood of the mention of a tax audit. Overall, our results are consistent with the IRS responding to signals of poor information quality or management integrity as if financial misreporting and tax reporting are related.

Can Big Data Defeat Traditional Credit Rating?

This paper examines the impact of large-scale alternative data on predicting consumer delinquency. Using a proprietary double-blinded test from a traditional lender, we find that the big data credit score predicts an individual’s likelihood of defaulting on a loan with 18.4% greater accuracy than the lender’s internal score. Moreover, the impact of the big data credit score is more significant when evaluating borrowers without public credit records. We also provide evidence that big data have the potential to correct financial misreporting.

CFO Gender and Financial Statement Irregularities

The increasing presence of women in upper echelon positions draws attention to the possible effects of executive gender on corporate decisions and actions. In this study, we formulate theory about the impact of CFO gender on financial misreporting to generate two key insights. First, we hypothesize that firms with female CFOs will have a lower likelihood of financial misreporting than comparable firms with male CFOs. Second, we argue that the relation between CFO gender and financial misreporting will be contingent on governance mechanisms (e.g., institutional ownership and analyst coverage) such that misreporting of firms with male CFOs will differ more from that of firms with female CFOs when governance is weak. Our results, based on a novel leading indicator of the likelihood of financial misreporting, provide support for our predictions. Various alternative econometric specifications, including (but not limited to) exogenous shocks, propensity score matching, and modeling treatment-effects, random effects, firm-fixed effects, and hybrid effects provide general support for our theory and hypotheses. Implications and directions for future research are discussed.

Trust, Buybacks and Equity Issues

CEO trustworthiness is positively related to long-term excess returns after buyback announcements. When the CEO is trustworthy, statements that the stock is undervalued are more credible. CEO trustworthiness is initially measured by the extent to which people in the county where the company headquarters is located trust each other. Further, the positive impact of trustworthiness on excess returns is higher when the CEO has been a long-term resident of a high-trust county, and correspondingly, trustworthy CEOs are less likely to be accused of financial misreporting. Our conclusions are confirmed when we use alternative measures of trustworthiness such as employee trust and CEO integrity.

Financial Reporting, Auditing, Analyst Scrutiny, and Investment Efficiency

This paper presents an economic framework to study strategic interactions along the analyst--auditor--owner monitoring chain in a financial reporting game and sheds light on possible consequences of various capital market regulations. We find that enhancing the analyst's independence alleviates financial misreporting and improves audit quality, analyst scrutiny, financial statement reliability, and investment efficiency. A surprising result emerges from the model that enhancing the auditor's legal liability and increasing the owner's misreporting cost might have unintended consequences in terms of their impacts on financial statement reliability and investment efficiency.

Financial Misreporting: Hiding in the Shadows or in Plain Sight?

This paper examines how the ex ante level of public scrutiny influences a manager’s subsequent decision to misreport. The conventional wisdom is that high levels of public scrutiny facilitate monitoring, suggesting a negative relation between scrutiny and misreporting. However, public scrutiny also increases the weight that investors place on earnings in valuing the firm. This in turn increases the benefit of misreporting, suggesting a positive relation. We formalize these two countervailing forces––monitoring and valuation––in the context of a parsimonious model of misreporting. We show that the combination of these two forces leads to a unimodal relation. Specifically, as the level of public scrutiny increases, misreporting first increases, reaches a peak, and then decreases. We find evidence of such a relation across multiple empirical measures of misreporting, multiple measures of public scrutiny, and multiple research designs.

Accounting Standard Precision, Corporate Governance, and Accounting Restatements

Prior research provides some evidence that strict corporate monitoring constrains financial misreporting. We examine whether the efficacy of various corporate monitoring mechanisms depends on the nature of accounting standards―rules-based standards (RBS) versus principles-based standards (PBS)―in place. We document that most features associated with tough monitoring by audit committees, boards, external auditors, and the Securities and Exchange Commission (SEC) are negatively associated with the likelihood of misstatements under RBS, but not misstatements under PBS. This evidence collectively suggests that most corporate gatekeepers likely fulfill their monitoring obligations primarily through ensuring better compliance with detailed standards when the applicable standards are more specific and leave less room for discretion. In contrast, our results imply that corporate monitors may fail to effectively constrain managerial opportunism when the standards are less specific and provide wider scope for discretion. We also find that misstatement duration decreases with strict monitoring under RBS, suggesting that timely detection is a channel through which corporate monitoring deters violations of RBS. Our core evidence is robust to using exogenous shocks to certain corporate monitoring functions mandated by the Sarbanes Oxley Act and stock exchanges. Relevant to the public policy discourse, our results lend some support that there is an institutional fit between the current corporate monitoring structure and rules-oriented accounting standards, while casting doubt on whether current corporate monitoring mechanisms would function effectively in the event that the U.S. financial reporting regime moves to a more principles-based framework.

External Labour Market Competitions and Stock Price Crash Risk: Evidence from Exposures to Competitor CEOs’ Award-Winning Events

This study examines whether chief executive officers’ (CEOs’) external labor market competitions affect their firms’ stock price crash risks. Using CEOs’ exposure to the prestigious media-award-winning events of competitor CEOs, we document a significant increase in stock crash risk for firms with award-exposed CEOs, compared with firms without such CEOs, and this treatment effect is attenuated by strong external monitoring and high-quality information environment, yet exacerbated by CEOs’ similarity with award winners and likelihood of winning the award. We further find that withholding bad news, risk taking, and financial misreporting are the possible channels through which competitor CEOs’ award events affect stock price crash risk. Our study sheds new light on the formerly under-researched adverse effects of CEO awards by suggesting that external labor market competition associated with CEO awards plays an important role in influencing extreme downside risk in the equity market.

Corporate Fraud, Public Enforcement, and the Dual Role of Investor Litigation

This paper studies strategic interactions between public and private enforcement of accounting regulation and their consequences for the deterrence of financial misreporting. We develop an economic model with a manager, a public enforcement agency, and an investor and derive equilibrium strategies for manipulative effort, routine investigative effort, and costly private litigation. Our main results are as follows. (i) Strengthening private enforcement unambiguously enhances deterrence, whereas strengthening public enforcement can exacerbate misreporting, due to a crowding out of private enforcement. We provide conditions under which (ii) the enforcer’s investigation incentives first increase and then decrease in the strength of private enforcement, (iii) public and private enforcement are strategic substitutes, (iv) the number of enforcement actions is misleading about public enforcement effectiveness, and (v) strengthening private enforcement decreases litigation risk. We also discuss implications of our results for empirical research.

Qualified foreign institutional investor ownership deregulation and the restatement of financial reports --- empirical findings from Taiwan

This study examines the monitoring role of qualified foreign institutional investors (QFIIs) on a financial misreporting by Taiwanese firms and whether this role has changed since the deregulation of QFII ownership restrictions. Empirical results reveal that, prior to deregulation, QFII ownership was negatively associated with the probability of financial report restatement, but this association disappeared in the post-deregulation period. Thus, the deregulation likely attracted a wide range of institution types (e.g., short-term oriented trading institutions) to engage in Taiwan's stock market, and this change in the composition of foreign institutions generally weakened the monitoring role of QFIIs to prevent financial misreporting. Further analysis documents that this result is more pronounced for firms with higher degrees of QFII ownership and lower shareholding volatility. The results are robust to various model specifications.

Gambling Attitudes and Financial Misreporting

AbstractWe investigate whether attitudes toward gambling help explain the occurrence of intentional misreporting. Similar to gambling, some financial reporting choices involve taking deliberate, speculative risks. We predict that in places where gambling is more socially acceptable, managers will be more likely to take financial reporting risks that increase the likelihood the financial statements will need to be restated. To test this prediction, we exploit geographic variation in local gambling attitudes and find that restatements due to intentional misreporting are more common in areas where gambling is more socially acceptable. This association is even stronger in situations where management is under greater pressure to misreport, including when the firm is close to meeting a performance benchmark, experiencing poor financial performance, or under investment‐related pressure. Furthermore, these results are robust to numerous tests to address omitted variables and endogeneity. Collectively, these findings suggest gambling attitudes help explain the incidence of intentional misreporting.

The Effect of Local Tournament Incentives on Firmss Performance, Risk-Taking Decisions, and Financial Reporting Decisions

This study documents the existence of local employment preferences for corporate executives and examines how the compensation of executives’ local peers affects their own performance, risk-taking decisions, and financial reporting decisions. We find that external hires of new CEOs (CFOs) are five (eight) times more likely to be from local firms than non-local firms. We also find that local tournament incentives—as proxied by the pay gap between an executive and higher-paid executives in the area—are associated with stronger performance, greater risk taking, and more financial misreporting. We find consistent results using a difference-in-difference analysis that exploits plausibly exogenous variation in local tournament incentives caused by the sudden death of a local CEO. Our findings are consistent with executives taking actions to compete for a promotion to a nearby firm with higher pay. In addition, we find the effect of local tournament incentives is larger when local mobility is greater and executives’ local preferences are stronger.